Toggle SGML Header (+)


Section 1: 10-Q (QUARTERLY REPORT)

 

 

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

Washington, DC 20549

 

FORM 10-Q

 

(Mark One) 

       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended March 31, 2018

 

OR

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _________ to_________

 

Commission File Number 0-25923

 

Eagle Bancorp, Inc. 

(Exact name of registrant as specified in its charter)

 

Maryland 52-2061461
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

 

7830 Old Georgetown Road, Third Floor, Bethesda, Maryland 20814
(Address of principal executive offices) (Zip Code)

 

(301) 986-1800 

(Registrant’s telephone number, including area code) 

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  ☒  No  ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ☒    No  ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company”) in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  ☒
Accelerated filer   ☐
Non-accelerated filer  ☐      (Do not mark if a smaller reporting company)
Smaller Reporting Company  ☐  
Emerging Growth Company   ☐  

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act 

Yes  ☐  No  ☒

 

As of April 30, 2018, the registrant had 34,306,285 shares of Common Stock outstanding.

 

 

 

 

EAGLE BANCORP, INC.

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION  
     
Item 1. Financial Statements (Unaudited) 3
  Consolidated Balance Sheets 3
 

Consolidated Statements of Operations 

4
  Consolidated Statements of Comprehensive Income  5
  Consolidated Statements of Changes in Shareholders’ Equity 6
  Consolidated Statements of Cash Flows 7
  Notes to Consolidated Financial Statements 8
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 42
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 64
     
Item 4. Controls and Procedures 64
     
PART II. OTHER INFORMATION 65
     
Item 1. Legal Proceedings 65
     
Item 1A. Risk Factors 65
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 65
     
Item 3. Defaults Upon Senior Securities 65
     
Item 4. Mine Safety Disclosures 65
     
Item 5. Other Information 65
     
Item 6. Exhibits 65
     
Signatures   68

 

 2 
Table of Contents  

 

Item 1 – Financial Statements (Unaudited)

 

 

EAGLE BANCORP, INC. 

Consolidated Balance Sheets (Unaudited) 

(dollars in thousands, except per share data)

 

Assets  March 31, 2018   December 31, 2017 
Cash and due from banks  $7,954   $7,445 
Federal funds sold   29,552    15,767 
Interest bearing deposits with banks and other short-term investments   167,347    167,261 
Investment securities available-for-sale, at fair value   578,317    589,268 
Federal Reserve and Federal Home Loan Bank stock   34,768    36,324 
Loans held for sale   25,873    25,096 
Loans   6,602,526    6,411,528 
Less allowance for credit losses   (65,807)   (64,758)
Loans, net   6,536,719    6,346,770 
Premises and equipment, net   19,808    20,991 
Deferred income taxes   30,203    28,770 
Bank owned life insurance   61,291    60,947 
Intangible assets, net   107,097    107,212 
Other real estate owned   1,394    1,394 
Other assets   97,737    71,784 
Total Assets  $7,698,060   $7,479,029 
           
Liabilities and Shareholders’ Equity          
Liabilities          
Deposits:          
Noninterest bearing demand  $1,909,210   $1,982,912 
Interest bearing transaction   366,986    420,417 
Savings and money market   2,767,721    2,621,146 
Time, $100,000 or more   598,307    515,682 
Other time   479,577    313,827 
Total deposits   6,121,801    5,853,984 
Customer repurchase agreements   48,365    76,561 
Other short-term borrowings   275,000    325,000 
Long-term borrowings   217,003    216,905 
Other liabilities   50,711    56,141 
Total Liabilities   6,712,880    6,528,591 
           
Shareholders’ Equity          
Common stock, par value $.01 per share; shares authorized 100,000,000, shares issued and outstanding 34,303,056 and 34,185,163, respectively   341    340 
Additional paid in capital   522,316    520,304 
Retained earnings   467,933    431,544 
Accumulated other comprehensive loss   (5,410)   (1,750)
Total Shareholders’ Equity   985,180    950,438 
Total Liabilities and Shareholders’ Equity  $7,698,060   $7,479,029 

 

See notes to consolidated financial statements.

 

 3 
Table of Contents  

 

EAGLE BANCORP, INC. 

Consolidated Statements of Operations (Unaudited) 

(dollars in thousands, except per share data)

 

   Three Months Ended March 31, 
   2018   2017 
Interest Income          
Interest and fees on loans  $84,430   $72,471 
Interest and dividends on investment securities   3,592    2,833 
Interest on balances with other banks and short-term investments   981    483 
Interest on federal funds sold   46    7 
Total interest income   89,049    75,794 
Interest Expense          
Interest on deposits   9,129    5,830 
Interest on customer repurchase agreements   50    38 
Interest on short-term borrowings   1,111    53 
Interest on long-term borrowings   2,979    2,979 
Total interest expense   13,269    8,900 
Net Interest Income   75,780    66,894 
Provision for Credit Losses   1,969    1,397 
Net Interest Income After Provision For Credit Losses   73,811    65,497 
           
Noninterest Income          
Service charges on deposits   1,614    1,472 
Gain on sale of loans   1,523    2,048 
Gain on sale of investment securities   42    505 
Increase in the cash surrender value of bank owned life insurance   344    367 
Other income   1,781    1,678 
Total noninterest income   5,304    6,070 
Noninterest Expense          
Salaries and employee benefits   16,858    16,677 
Premises and equipment expenses   3,929    3,847 
Marketing and advertising   937    894 
Data processing   2,317    2,041 
Legal, accounting and professional fees   2,973    1,002 
FDIC insurance   675    544 
Other expenses   3,432    4,227 
Total noninterest expense   31,121    29,232 
Income Before Income Tax Expense   47,994    42,335 
Income Tax Expense   12,279    15,318 
Net Income  $35,715   $27,017 
           
Earnings Per Common Share          
Basic  $1.04   $0.79 
Diluted  $1.04   $0.79 

 

See notes to consolidated financial statements. 

 

 4 
Table of Contents  

 

EAGLE BANCORP, INC. 

Consolidated Statements of Comprehensive Income (Unaudited) 

(dollars in thousands)

 

   Three Months Ended March 31, 
   2018   2017 
         
Net Income  $35,715   $27,017 
           
Other comprehensive income, net of tax:          
Unrealized (loss) gain on securities available for sale   (5,123)   712 
Reclassification adjustment for net gains included in net income   (31)   (322)
Total unrealized loss on investment securities   (5,154)   390 
Unrealized gain on derivatives   2,233    1,079 
Reclassification adjustment for amounts included in net income   (65)   (369)
Total unrealized gain on derivatives   2,168    710 
Other comprehensive (loss) income   (2,986)   1,100 
Comprehensive Income  $32,729   $28,117 

 

See notes to consolidated financial statements.

 

 5 
Table of Contents  

 

EAGLE BANCORP, INC. 

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) 

(dollars in thousands except share data)

 

                    Accumulated     
            Additional       Other   Total 
   Common    Paid   Retained   Comprehensive   Shareholders’ 
   Shares   Amount    in Capital   Earnings   Income (Loss)   Equity 
                          
Balance January 1, 2018   34,185,163   $340    $520,304   $431,544   $(1,750)  $950,438 
                                
Net Income                35,715        35,715 
Other comprehensive loss, net of tax                    (2,986)   (2,986)
Stock-based compensation expense            1,476            1,476 
Issuance of common stock related to options exercised, net of shares withheld for payroll taxes   32,230         338            338 
Vesting of time based stock awards issued at date of grant, net of shares withheld for payroll taxes   (12,106)   1     (1)            
Time based stock awards granted   94,344                      
Issuance of common stock related to employee stock purchase plan   3,425         199            199 
Reclassification of the income tax effects of the Tax Cuts and Jobs Act from AOCI (ASU 2018-02)                674    (674)    
Balance March 31, 2018   34,303,056   $341    $522,316   $467,933   $(5,410)  $985,180 
                                
Balance January 1, 2017   34,023,850   $338    $513,531   $331,311   $(2,381)  $842,799 
                                
Net Income                27,017        27,017 
Other comprehensive income, net of tax                    1,100    1,100 
Stock-based compensation expense            1,856            1,856 
Issuance of common stock related to options exercised, net of shares withheld for payroll taxes   2,675         66            66 
Vesting of time based stock awards issued at date of grant, net of shares withheld for payroll taxes   (11,788)   1     (2)           (1)
Time based stock awards granted   91,097                      
Issuance of common stock related to employee stock purchase plan   4,222         205            205 
Balance March 31, 2017   34,110,056   $339    $515,656   $358,328   $(1,281)  $873,042 

 

See notes to consolidated financial statements.

 

 6 
Table of Contents  

 

EAGLE BANCORP, INC. 

Consolidated Statements of Cash Flows (Unaudited) 

(dollars in thousands)

 

   Three Months Ended March 31, 
   2018   2017 
Cash Flows From Operating Activities:          
Net Income  $35,715   $27,017 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   1,969    1,397 
Depreciation and amortization   1,811    1,772 
Gains on sale of loans   (1,523)   (2,048)
Securities premium amortization (discount accretion), net   1,087    1,006 
Origination of loans held for sale   (102,316)   (153,995)
Proceeds from sale of loans held for sale   103,062    178,105 
Net increase in cash surrender value of BOLI   (344)   (367)
(Increase) decrease deferred income tax benefit   (1,433)   17 
Net loss on sale of other real estate owned       361 
Net gain on sale of investment securities   (42)   (505)
Stock-based compensation expense   1,476    1,856 
Net tax benefits from stock compensation   108    589 
Increase in other assets   (25,519)   (594)
(Decrease) increase in other liabilities   (5,430)   7,478 
Net cash provided by operating activities   8,621    62,089 
Cash Flows From Investing Activities:          
Purchases of available for sale investment securities   (32,269)   (35,183)
Proceeds from maturities of available for sale securities   21,249    22,922 
Proceeds from sale/call of available for sale securities   17,266    51,161 
Purchases of Federal Reserve and Federal Home Loan Bank stock   (28,322)   (8,275)
Proceeds from redemption of Federal Reserve and Federal Home Loan Bank stock   29,878    4,302 
Net increase in loans   (191,918)   (147,618)
Proceeds from sale of other real estate owned       939 
Bank premises and equipment acquired   (283)   (1,248)
Net cash used in investing activities   (184,399)   (113,000)
Cash Flows From Financing Activities:          
Increase in deposits   267,817    73,375 
(Decrease) increase in customer repurchase agreements   (28,196)   13,284 
(Decrease) increase in short-term borrowings   (50,000)   75,000 
Proceeds from exercise of equity compensation plans   338    66 
Proceeds from employee stock purchase plan   199    205 
Net cash provided by financing activities   190,158    161,930 
Net Increase In Cash and Cash Equivalents   14,380    111,019 
Cash and Cash Equivalents at Beginning of Period   190,473    368,163 
Cash and Cash Equivalents at End of Period  $204,853   $479,182 
Supplemental Cash Flows Information:          
Interest paid  $15,352   $11,517 
Income taxes paid  $16,500   $6,000 
Non-Cash Investing Activities          
Transfers from loans to other real estate owned  $   $ 
Transfers from other real estate owned to loans  $   $ 

 

See notes to consolidated financial statements.

 

 7 
Table of Contents  

 

EAGLE BANCORP, INC. 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

(Unaudited)

 

Note 1. Summary of Significant Accounting Policies

 

Basis of Presentation

 

The Consolidated Financial Statements include the accounts of Eagle Bancorp, Inc. and its subsidiaries (the “Company”), EagleBank (the “Bank”), Eagle Commercial Ventures, LLC (“ECV”), Eagle Insurance Services, LLC, and Bethesda Leasing, LLC, with all significant intercompany transactions eliminated.

 

The Consolidated Financial Statements of the Company included herein are unaudited. The Consolidated Financial Statements reflect all adjustments, consisting of normal recurring accruals that in the opinion of management, are necessary to present fairly the results for the periods presented. The amounts as of and for the year ended December 31, 2017 were derived from audited Consolidated Financial Statements. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. There have been no significant changes to the Company’s Accounting Policies as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The Company believes that the disclosures are adequate to make the information presented not misleading. Certain reclassifications have been made to amounts previously reported to conform to the current period presentation.

 

These statements should be read in conjunction with the audited Consolidated Financial Statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. Operating results for the three months ended March 31, 2018 are not necessarily indicative of the results of operations to be expected for the remainder of the year, or for any other period.

 

Nature of Operations

 

The Company, through the Bank, conducts a full service community banking business, primarily in Northern Virginia, Suburban Maryland, and Washington, D.C. The primary financial services offered by the Bank include real estate, commercial and consumer lending, as well as traditional deposit and repurchase agreement products. The Bank is also active in the origination and sale of residential mortgage loans, the origination of small business loans, and the origination, securitization and sale of multifamily FHA loans. The guaranteed portion of small business loans, guaranteed by the Small Business Administration (“SBA”), is typically sold to third party investors in a transaction apart from the loan’s origination. The Bank offers its products and services through twenty banking offices, five lending centers and various electronic capabilities, including remote deposit services and mobile banking services. Eagle Insurance Services, LLC, a subsidiary of the Bank, offers access to insurance products and services through a referral program with a third party insurance broker. Eagle Commercial Ventures, LLC, a direct subsidiary of the Company, has provided subordinated financing for the acquisition, development and construction of real estate projects; these transactions involve higher levels of risk, together with commensurate higher returns.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Actual results may differ from those estimates and such differences could be material to the financial statements.

 

New Authoritative Accounting Guidance

 

Accounting Standards Adopted in 2018

 

ASU 2014-09, “Revenue from Contracts with Customers (Topic 606).” The amendments in ASU 2014-09 supersede the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance. The general principle of the amendments require an entity to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance sets forth a five step approach to be utilized for revenue recognition. The Company completed its overall assessment of revenue streams and review of related contracts potentially affected by the ASU, including deposit related fees, interchange fees, and merchant income. Based on this assessment, the Company concluded that ASU 2014-09 did not materially change the method in which the Company currently recognizes revenue for these revenue streams. The Company also completed its evaluation of certain costs related to these revenue streams to determine whether such costs should be presented as expenses or contra-revenue (i.e., gross vs. net). Based on its evaluation, the Company did not identify revenue streams within the scope of ASC 606 that required a material change in their presentation under the gross vs. net requirement of ASC 606. The Company adopted ASU 2014-09 and its related amendments on its required effective date of January 1, 2018 utilizing the modified retrospective approach. Since there was no net income impact upon adoption of the new guidance, a cumulative effect adjustment to opening retained earnings was not deemed necessary. Consistent with the modified retrospective approach, the Company did not adjust prior period amounts.

 

 8 
Table of Contents  

 

The majority of our revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as our loans, letters of credit, derivatives and investment securities, as well as revenue related to our mortgage servicing activities, as these activities are subject to other GAAP discussed elsewhere within our disclosures. Substantially all of the Company’s revenue is generated from contracts with customers. Descriptions of our revenue-generating activities that are within the scope of ASC 606, which are presented in our income statements as components of noninterest income are as follows:

 

Service charges on deposit accounts - these represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when our performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied.
   
Other Fees – generally, the Company receives compensation when a customer that it refers opens an account with certain third-parties. This category includes credit card, investment advisory, and interchange fees. The timing and amount of revenue recognition is not materially impacted by the new standard.
   
Sale of OREO – ASU 2014-09 prescribes derecognition requirements for the sale of OREO that are less prescriptive than existing derecognition requirements. Previously, the Company was required to assess 1) the adequacy of a buyer’s initial and continuing investments and 2) the seller’s continuing involvement with the property. ASU 2014-09 requires an entity to assess whether it is “probable” that it will collect the consideration to which it will be entitled in exchange for transferring the asset to the customer. The new requirements could result in earlier revenue recognition; however, such sales are infrequent and the impact of this change is not expected to be material to our financial statements.

 

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals based on fee schedules. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into long-term revenue contracts with customers, and therefore, does not have contract balances material to our financial statements. As of March 31, 2018 and December 31, 2017, the Company did not have any significant contract balances.

 

In connection with the adoption of Topic 606, an entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. Upon adoption of Topic 606, the Company did not capitalize any contract acquisition cost.

 

 9 
Table of Contents  

 

ASU 2016-01, “Financial Instruments—(Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments by making targeted improvements to GAAP as follows: (1) require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer; (2) simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, an entity is required to measure the investment at fair value; (3) eliminate the requirement to disclose the fair value of financial instruments measured at amortized cost for entities that are not public business entities; (4) eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (5) require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (6) require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (7) require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements; and (8) clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU No. 2016-01 was effective for us effective January 1, 2018 and did not have a material impact on our Consolidated Financial Statements. Refer to Note 12 for the valuation of the loan portfolio using the exit price notion.

 

ASU 2016-15 “Statement of Cash Flows (Topic 230)” is intended to reduce the diversity in practice around how certain transactions are classified within the statement of cash flows. ASU 2016-15 became effective for us on January 1, 2018 and did not have a significant impact on our financial statements.

 

ASU 2017-12, “Derivatives and Hedging (Topic 815) - Targeted Improvements to Accounting for Hedging Activities”. ASU 2017-12 amends the hedge accounting recognition and presentation requirements in ASC 815 to improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities to better align the entity’s financial reporting for hedging relationships with those risk management activities and to reduce the complexity of and simplify the application of hedge accounting. The Company early adopted ASU 2017-12 effective January 1, 2018. The new standard did not have a material impact to our Consolidated Financial Statements.

 

ASU 2018-02, “Income Statement - Reporting Comprehensive Income (Topic 220)- Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income”. ASU 2018-02 allows a reclassification from accumulated other comprehensive income (loss) (“AOCI”) to retained earnings for the stranded tax effects caused by the revaluation of deferred taxes resulting from the newly enacted corporate tax rate in the Tax Cuts and Jobs Act of 2017. The ASU is effective in years beginning after December 15, 2018, but permits early adoption in a period for which financial statements have not yet been issued. We have elected to early adopt the ASU as of January 1, 2018. The adoption of the guidance resulted in a $674 thousand cumulative-effect adjustment, done on a portfolio basis, to reclassify the income tax effects resulting from tax reform from AOCI to retained earnings. The adjustment increased retained earnings and decreased AOCI in the first quarter of 2018.

 

Accounting Standards Pending Adoption

 

ASU 2016-02, “Leases (Topic 842).” Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases): (1) a lease liability, which is the present value of a lessee’s obligation to make lease payments, and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Lessor accounting under the new guidance remains largely unchanged as it is substantially equivalent to existing guidance for sales-type leases, direct financing leases, and operating leases. Leveraged leases have been eliminated, although lessors can continue to account for existing leveraged leases using the current accounting guidance. Other limited changes were made to align lessor accounting with the lessee accounting model and the new revenue recognition standard. All entities will classify leases to determine how to recognize lease-related revenue and expense. Quantitative and qualitative disclosures will be required by lessees and lessors to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The intention is to require enough information to supplement the amounts recorded in the financial statements so that users can understand more about the nature of an entity’s leasing activities. ASU 2016-02 is effective for interim and annual reporting periods beginning after December 15, 2018; early adoption is permitted. All entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. They have the option to use certain relief; full retrospective application is prohibited. The Company is currently evaluating the provisions of ASU 2016-02, researching software to aid in the transition to the new leasing guidance, and will be closely monitoring developments and additional guidance to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

 10 
Table of Contents  

 

ASU 2016-13, “Measurement of Credit Losses on Financial Instruments (Topic 326).” This ASU significantly changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. In issuing the standard, the FASB is responding to criticism that today’s guidance delays recognition of credit losses. The standard will replace today’s “incurred loss” approach with an “expected loss” model. The new model, referred to as the current expected credit loss (“CECL”) model, will apply to: (1) financial assets subject to credit losses and measured at amortized cost, and (2) certain off-balance sheet credit exposures. This includes, but is not limited to, loans, leases, held-to-maturity securities, loan commitments, and financial guarantees. The CECL model does not apply to available-for-sale (“AFS”) debt securities. For AFS debt securities with unrealized losses, entities will measure credit losses in a manner similar to what they do today, except that the losses will be recognized as allowances rather than reductions in the amortized cost of the securities. As a result, entities will recognize improvements to estimated credit losses immediately in earnings rather than as interest income over time, as they do today. The ASU also simplifies the accounting model for purchased credit-impaired debt securities and loans. ASU 2016-13 also expands the disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the allowance for loan and lease losses. In addition, entities will need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. ASU No. 2016-13 is effective for us beginning on January 1, 2020; early adoption is permitted for us beginning on January 1, 2019. Entities will apply the standard’s provisions as a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (i.e., modified retrospective approach). We have substantially concluded our data gap analysis and have contracted with a third party to develop a model to comply with CECL requirements. We have established a steering committee with representation from various departments across the enterprise. The committee has agreed to a project plan and we have regular meetings to ensure adherence to our implementation timeline. The Company is currently evaluating the provisions of ASU No. 2016-13 to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

 

ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350) - Simplifying the Test for Goodwill Impairment”. ASU 2017-04 eliminates Step 2 from the goodwill impairment test which required entities to compute the implied fair value of goodwill. Under ASU 2017-04, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. ASU 2017-04 will be effective for us on January 1, 2020, with early adoption permitted for interim or annual impairment tests beginning in 2017, and is not expected to have a significant impact on our consolidated financial statements. We expect to implement ASU 2017-04 prior to 2018 year-end.

 

Note 2. Cash and Due from Banks

 

Regulation D of the Federal Reserve Act requires that banks maintain noninterest reserve balances with the Federal Reserve Bank based principally on the type and amount of their deposits. During 2018, the Bank maintained balances at the Federal Reserve sufficient to meet reserve requirements, as well as significant excess reserves, on which interest is paid.

 

Additionally, the Bank maintains interest bearing balances with the Federal Home Loan Bank of Atlanta and noninterest bearing balances with domestic correspondent banks as compensation for services they provide to the Bank.

 

 11 
Table of Contents  

 

Note 3. Investment Securities Available-for-Sale

 

Amortized cost and estimated fair value of securities available-for-sale are summarized as follows:

 

       Gross   Gross   Estimated 
March 31, 2018  Amortized   Unrealized   Unrealized   Fair 
(dollars in thousands)  Cost   Gains   Losses   Value 
U. S. agency securities  $196,210   $130  $4,249   $192,091 
Residential mortgage backed securities   337,362    113    8,235    329,240 
Municipal bonds   48,577    642    614    48,605 
Corporate bonds   8,004    159        8,163 
Other equity investments   218            218 
   $590,371   $1,044   $13,098   $578,317 

 

        Gross     Gross     Estimated  
December 31, 2017   Amortized     Unrealized     Unrealized     Fair  
(dollars in thousands)   Cost     Gains     Losses     Value  
U. S. agency securities  $198,115   $283  $2,414   $195,984 
Residential mortgage backed securities   322,067    187    4,418    317,836 
Municipal bonds   60,976    1,295    214    62,057 
Corporate bonds   13,010    163        13,173 
Other equity investments   218            218 
   $594,386   $1,928   $7,046   $589,268 

 

In addition, at March 31, 2018 and December 31, 2017 the Company held $34.8 million and $36.3 million, respectively, in equity securities in a combination of Federal Reserve Bank (“FRB”) and Federal Home Loan Bank (“FHLB”) stocks, which are required to be held for regulatory purposes and which are not marketable, and therefore are carried at cost.

 

 12 
Table of Contents  

 

Gross unrealized losses and fair value by length of time that the individual available-for-sale securities have been in a continuous unrealized loss position are as follows:

 

       Less than   12 Months     
       12 Months   or Greater   Total 
       Estimated       Estimated       Estimated     
March 31, 2018  Number of   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
(dollars in thousands)  Securities   Value   Losses   Value   Losses   Value   Losses 
U. S. agency securities   44   $113,476   $2,469   $54,634   $1,780   $168,110   $4,249 
Residential mortgage backed securities   148    159,464    3,326    146,174    4,909    305,638    8,235 
Municipal bonds   13    23,180    614            23,180    614 
    205   $296,120   $6,409   $200,808   $6,689   $496,928   $13,098 

 

       Less than   12 Months     
       12 Months   or Greater   Total 
       Estimated       Estimated       Estimated     
December 31, 2017  Number of   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
(dollars in thousands)  Securities   Value   Losses   Value   Losses   Value   Losses 
U. S. agency securities   38   $102,264   $1,073   $55,093   $1,341   $157,357   $2,414 
Residential mortgage backed securities   137    152,350    1,306    147,953    3,112    300,303    4,418 
Municipal bonds   8    17,446    214            17,446    214 
    183   $272,060   $2,593   $203,046   $4,453   $475,106   $7,046 

 

The unrealized losses that exist are generally the result of changes in market interest rates and interest spread relationships since original purchases. The weighted average duration of debt securities, which comprise 99.9% of total investment securities, is relatively short at 3.8 years. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. The Company does not believe that the investment securities that were in an unrealized loss position as of March 31, 2018 represent an other-than-temporary impairment. The Company does not intend to sell the investments and it is more likely than not that the Company will not have to sell the securities before recovery of its amortized cost basis, which may be at maturity.

 

The amortized cost and estimated fair value of investments available-for-sale at March 31, 2018 and December 31, 2017 by contractual maturity are shown in the table below. Expected maturities for residential mortgage backed securities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   March 31, 2018   December 31, 2017 
   Amortized   Estimated   Amortized   Estimated 
(dollars in thousands)  Cost   Fair Value   Cost   Fair Value 
U. S. agency securities maturing:                    
   One year or less  $111,940   $108,886   $109,893   $108,198 
   After one year through five years   70,523    69,917    74,106    73,916 
   Five years through ten years   13,747    13,288    14,116    13,870 
Residential mortgage backed securities   337,362    329,240    322,067    317,836 
Municipal bonds maturing:                    
   One year or less   5,078    5,139    5,068    5,171 
   After one year through five years   19,366    19,654    19,405    19,879 
   Five years through ten years   23,064    22,686    35,432    35,846 
   After ten years   1,069    1,126    1,071    1,161 
Corporate bonds maturing:                    
   After one year through five years    6,504    6,663    11,510    11,673 
   After ten years   1,500    1,500    1,500    1,500 
Other equity investments   218    218    218    218 
   $590,371   $578,317   $594,386   $589,268 

 

For the three months ended March 31, 2018, gross realized gains on sales of investments securities were $67 thousand and gross realized losses on sales of investment securities were $25 thousand. For the year ended December 31, 2017, gross realized gains on sales of investment securities were $796 thousand and gross realized losses on sales of investment securities were $254 thousand.

 

 13 
Table of Contents  

 

Proceeds from sales and calls of investment securities for the three months ended March 31, 2018 were $17.3 million compared to $51.2 million for the same period in 2017.

 

The carrying value of securities pledged as collateral for certain government deposits, securities sold under agreements to repurchase, and certain lines of credit with correspondent banks at March 31, 2018 and December 31, 2017 was $454.8 million and $465.4 million, respectively, which is well in excess of required amounts in order to operationally provide significant reserve amounts for new business. As of March 31, 2018 and December 31, 2017, there were no holdings of securities of any one issuer, other than the U.S. Government and U.S. agency securities, which exceeded ten percent of shareholders’ equity.

 

Note 4. Mortgage Banking Derivative

 

As part of its mortgage banking activities, the Bank enters into interest rate lock commitments, which are commitments to originate loans where the interest rate on the loan is determined prior to funding and the customers have locked into that interest rate. The Bank then locks in the loan and interest rate with an investor and commits to deliver the loan if settlement occurs (“best efforts”) or commits to deliver the locked loan in a binding (“mandatory”) delivery program with an investor. Certain loans under interest rate lock commitments are covered under forward sales contracts of mortgage backed securities (“MBS”). Forward sales contracts of MBS are recorded at fair value with changes in fair value recorded in noninterest income. Interest rate lock commitments and commitments to deliver loans to investors are considered derivatives. The market value of interest rate lock commitments and best efforts contracts are not readily ascertainable with precision because they are not actively traded in stand-alone markets. The Bank determines the fair value of interest rate lock commitments and delivery contracts by measuring the fair value of the underlying asset, which is impacted by current interest rates, taking into consideration the probability that the interest rate lock commitments will close or will be funded.

 

Certain additional risks arise from these forward delivery contracts in that the counterparties to the contracts may not be able to meet the terms of the contracts. The Bank does not expect any counterparty to any MBS to fail to meet its obligation. Additional risks inherent in mandatory delivery programs include the risk that, if the Bank does not close the loans subject to interest rate risk lock commitments, it will still be obligated to deliver MBS to the counterparty under the forward sales agreement. Should this be required, the Bank could incur significant costs in acquiring replacement loans or MBS and such costs could have an adverse effect on mortgage banking operations.

 

The fair value of the mortgage banking derivatives is recorded as a freestanding asset or liability with the change in value being recognized in current earnings during the period of change.

 

At March 31, 2018 the Bank had mortgage banking derivative financial instruments with a notional value of $55.3 million related to its forward contracts as compared to $37.1 million at December 31, 2017. The fair value of these mortgage banking derivative instruments at March 31, 2018 was $51 thousand included in other assets and $84 thousand included in other liabilities as compared to $43 thousand included in other assets and $10 thousand included in other liabilities at December 31, 2017.

 

Included in other noninterest income for the three months ended March 31, 2018 was a net loss of $87 thousand, relating to mortgage banking derivative instruments as compared to a net gain of $290 thousand as of March 31, 2017. The amount included in other noninterest income for the three months ended March 31, 2018 pertaining to its mortgage banking hedging activities was a net realized gain of $91 thousand as compared to a net realized loss of $845 thousand as of March 31, 2017.

 

Note 5. Loans and Allowance for Credit Losses

 

The Bank makes loans to customers primarily in the Washington, D.C. metropolitan area and surrounding communities. A substantial portion of the Bank’s loan portfolio consists of loans to businesses secured by real estate and other business assets.

 

 14 
Table of Contents  

 

Loans, net of unamortized net deferred fees, at March 31, 2018 and December 31, 2017 are summarized by type as follows:

 

   March 31, 2018   December 31, 2017 
(dollars in thousands)  Amount   %   Amount   % 
Commercial  $1,426,042    22%  $1,375,939    21%
Income producing - commercial real estate   3,137,498    47%   3,047,094    48%
Owner occupied - commercial real estate   800,747    12%   755,444    12%
Real estate mortgage - residential   103,932    2%   104,357    2%
Construction - commercial and residential   1,000,266    15%   973,141    15%
Construction - C&I (owner occupied)   40,547    1%   58,691    1%
Home equity   90,271    1%   93,264    1%
Other consumer   3,223        3,598     
    Total loans   6,602,526    100%   6,411,528    100%
Less: allowance for credit losses   (65,807)        (64,758)     
   Net loans  $6,536,719        $6,346,770      

 

Unamortized net deferred fees amounted to $24.3 million and $23.9 million at March 31, 2018 and December 31, 2017, respectively.

 

As of March 31, 2018 and December 31, 2017, the Bank serviced $208.7 million and $195.3 million, respectively, of multifamily FHA loans, SBA loans and other loan participations which are not reflected as loan balances on the Consolidated Balance Sheets.

 

Loan Origination / Risk Management

 

The Company’s goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include: carefully enforcing loan policies and procedures, evaluating each borrower’s business plan during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and obtaining collateral to mitigate economic loss in the event of liquidation. Specific loan reserves are established based upon credit and/or collateral risks on an individual loan basis. A risk rating system is employed to proactively estimate loss exposure and provide a measuring system for setting general and specific reserve allocations.

 

The composition of the Company’s loan portfolio is heavily weighted toward commercial real estate, both owner occupied and income producing real estate. At March 31, 2018, owner occupied - commercial real estate and construction - C&I (owner occupied) represent approximately 13% of the loan portfolio. At March 31, 2018, non-owner occupied commercial real estate and real estate construction represented approximately 62% of the loan portfolio. The combined owner occupied and commercial real estate loans represent approximately 75% of the loan portfolio. These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow and general economic conditions. The Bank typically requires a maximum loan to value of 80% and minimum cash flow debt service coverage of 1.15 to 1.0. Personal guarantees may be required, but may be limited. In making real estate commercial mortgage loans, the Bank generally requires that interest rates adjust not less frequently than five years.

 

The Company is also an active traditional commercial lender providing loans for a variety of purposes, including working capital, equipment and account receivable financing. This loan category represents approximately 22% of the loan portfolio at March 31, 2018 and was generally variable or adjustable rate. Commercial loans meet reasonable underwriting standards, including appropriate collateral and cash flow necessary to support debt service. Personal guarantees are generally required, but may be limited. SBA loans represent approximately 2% of the commercial loan category of loans. In originating SBA loans, the Company assumes the risk of non-payment on the unguaranteed portion of the credit. The Company generally sells the guaranteed portion of the loan generating noninterest income from the gains on sale, as well as servicing income on the portion participated. SBA loans are subject to the same cash flow analyses as other commercial loans. SBA loans are subject to a maximum loan size established by the SBA as well as internal loan size guidelines.

 

 15 
Table of Contents  

 

Approximately 1% of the loan portfolio at March 31, 2018 consists of home equity loans and lines of credit and other consumer loans. These credits, while making up a small portion of the loan portfolio, demand the same emphasis on underwriting and credit evaluation as other types of loans advanced by the Bank.

 

Approximately 2% of the loan portfolio consists of residential mortgage loans. The repricing duration of these loans was 19 months. These credits represent first liens on residential property loans originated by the Bank. While the Bank’s general practice is to originate and sell (servicing released) loans made by its Residential Lending department, from time to time certain loan characteristics do not meet the requirements of third party investors and these loans are instead maintained in the Bank’s portfolio until they are resold to another investor at a later date or mature.

 

Loans are secured primarily by duly recorded first deeds of trust or mortgages. In some cases, the Bank may accept a recorded junior trust position. In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is customarily required.

 

Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Bank. Guaranteed, fixed price contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.

 

Loans intended for residential land acquisition, lot development and construction are made on the premise that the land: 1) is or will be developed for building sites for residential structures, and; 2) will ultimately be utilized for construction or improvement of residential zoned real properties, including the creation of housing. Residential development and construction loans will finance projects such as single family subdivisions, planned unit developments, townhouses, and condominiums. Residential land acquisition, development and construction loans generally are underwritten with a maximum term of 36 months, including extensions approved at origination.

 

Commercial land acquisition and construction loans are secured by real property where loan funds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties. Borrowers are generally required to put equity into each project at levels determined by the appropriate Loan Committee. Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months.

 

Substantially all construction draw requests must be presented in writing on American Institute of Architects documents and certified either by the contractor, the borrower and/or the borrower’s architect. Each draw request shall also include the borrower’s soft cost breakdown certified by the borrower or their Chief Financial Officer. Prior to an advance, the Bank or its contractor inspects the project to determine that the work has been completed, to justify the draw requisition.

 

Commercial permanent loans are generally secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan. The debt service coverage ratio is ordinarily at least 1.15 to 1.0. As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

 

Commercial permanent loans generally are underwritten with a term not greater than 10 years or the remaining useful life of the property, whichever is lower. The preferred term is between 5 to 7 years, with amortization to a maximum of 25 years.

 

 16 
Table of Contents  

 

The Company’s loan portfolio includes ADC real estate loans including both investment and owner occupied projects. ADC loans amounted to $1.43 billion at March 31, 2018. A portion of the ADC portfolio, both speculative and non-speculative, includes loan funded interest reserves at origination. ADC loans that provide for the use of interest reserves represent approximately 81% of the outstanding ADC loan portfolio at March 31, 2018. The decision to establish a loan-funded interest reserve is made upon origination of the ADC loan and is based upon a number of factors considered during underwriting of the credit including: (1) the feasibility of the project; (2) the experience of the sponsor; (3) the creditworthiness of the borrower and guarantors; (4) borrower equity contribution; and (5) the level of collateral protection. When appropriate, an interest reserve provides an effective means of addressing the cash flow characteristics of a properly underwritten ADC loan. The Company does not significantly utilize interest reserves in other loan products. The Company recognizes that one of the risks inherent in the use of interest reserves is the potential masking of underlying problems with the project and/or the borrower’s ability to repay the loan. In order to mitigate this inherent risk, the Company employs a series of reporting and monitoring mechanisms on all ADC loans, whether or not an interest reserve is provided, including: (1) construction and development timelines which are monitored on an ongoing basis which track the progress of a given project to the timeline projected at origination; (2) a construction loan administration department independent of the lending function; (3) third party independent construction loan inspection reports; (4) monthly interest reserve monitoring reports detailing the balance of the interest reserves approved at origination and the days of interest carry represented by the reserve balances as compared to the then current anticipated time to completion and/or sale of speculative projects; and (5) quarterly commercial real estate construction meetings among senior Company management, which includes monitoring of current and projected real estate market conditions. If a project has not performed as expected, it is not the customary practice of the Company to increase loan funded interest reserves.

 

 17 
Table of Contents  

 

The following tables detail activity in the allowance for credit losses by portfolio segment for the three months ended March 31, 2018 and 2017. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

       Income
Producing -
   Owner
Occupied -
   Real Estate   Construction -
Commercial
             
       Commercial   Commercial   Mortgage   and   Home   Other     
(dollars in thousands)  Commercial   Real Estate   Real Estate   Residential   Residential   Equity   Consumer   Total 
Three months ended March 31, 2018                                        
Allowance for credit losses:                                        
Balance at beginning of period  $13,102   $25,376   $5,934   $944   $18,492   $770   $140   $64,758 
Loans charged-off   (853)   (121)   (132)                   (1,106)
Recoveries of loans previously
charged-off
   3        1    2    60    117    3    186 
Net loans (charged-off) recoveries   (850)   (121)   (131)   2    60    117    3    (920)
Provision for credit losses   1,106    1,213    (332)   (212)   190    (188)   192    1,969 
Ending balance  $13,358   $26,468   $5,471   $734   $18,742   $699   $335   $65,807 
As of March 31, 2018                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $3,014   $2,628   $500   $   $500   $   $80   $6,722 
Collectively evaluated for impairment   10,344    23,840    4,971    734    18,242    699    255    59,085 
Ending balance  $13,358   $26,468   $5,471   $734   $18,742   $699   $335   $65,807 
                                         
Three months ended March 31, 2017                                        
Allowance for credit losses:                                        
Balance at beginning of period  $14,700   $21,105   $4,010   $1,284   $16,487   $1,328   $160   $59,074 
Loans charged-off   (137)   (500)                   (63)   (700)
Recoveries of loans previously
charged-off
   13    50    1    2    3    1    7    77 
Net loans (charged-off) recoveries   (124)   (450)   1    2    3    1    (56)   (623)
Provision for credit losses   7    729    15    (180)   866    (241)   201    1,397 
Ending balance  $14,583   $21,384   $4,026   $1,106   $17,356   $1,088   $305   $59,848 
As of March 31, 2017                                        
Allowance for credit losses:                                        
Individually evaluated for impairment  $3,030   $1,488   $350   $   $350   $   $50   $5,268 
Collectively evaluated for impairment   11,553    19,896    3,676    1,106    17,006    1,088    255    54,580 
Ending balance  $14,583   $21,384   $4,026   $1,106   $17,356   $1,088   $305   $59,848 

 

 18 
Table of Contents  

 

The Company’s recorded investments in loans as of March 31, 2018 and December 31, 2017 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Company’s impairment methodology was as follows:

 

       Income Producing -   Owner Occupied -   Real Estate   Construction -
Commercial
             
       Commercial   Commercial   Mortgage   and   Home   Other     
(dollars in thousands)  Commercial   Real Estate   Real Estate   Residential   Residential   Equity   Consumer   Total 
                                 
March 31, 2018                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $15,468   $9,394   $7,771   $1,451   $4,707   $494   $91   $39,376 
Collectively evaluated for impairment   1,410,574    3,128,104    792,976    102,481    1,036,106    89,777    3,132    6,563,150 
Ending balance  $1,426,042   $3,137,498   $800,747   $103,932   $1,040,813   $90,271   $3,223   $6,602,526 
                                         
December 31, 2017                                        
Recorded investment in loans:                                        
Individually evaluated for impairment  $8,726   $10,192   $5,501   $478   $4,709   $494   $91   $30,191 
Collectively evaluated for impairment   1,367,213    3,036,902    749,943    103,879    1,027,123    92,770    3,507    6,381,337 
Ending balance  $1,375,939   $3,047,094   $755,444   $104,357   $1,031,832   $93,264   $3,598   $6,411,528 

 

At March 31, 2018, nonperforming loans acquired from Fidelity & Trust Financial Corporation (“Fidelity”) and Virginia Heritage Bank (“Virginia Heritage”) have a carrying value of $321 thousand and $452 thousand, and an unpaid principal balance of $379 thousand and $1.5 million, respectively, and were evaluated separately in accordance with ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality.” At December 31, 2017, nonperforming loans acquired from Fidelity and Virginia Heritage had a carrying value of $297 thousand and $479 thousand, respectively, and an unpaid principal balance of $347 thousand and $1.5 million, respectively, and were evaluated separately in accordance with ASC Topic 310-30. The various impaired loans were recorded at estimated fair value with any excess being charged-off or treated as a non-accretable discount. Subsequent downward adjustments to the valuation of impaired loans acquired will result in additional loan loss provisions and related allowance for credit losses.

 

 19 
Table of Contents  

 

Credit Quality Indicators

 

The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company’s primary credit quality indicators are to use an internal credit risk rating system that categorizes loans into pass, watch, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans to businesses or individuals in the classes which comprise the commercial portfolio segment. Groups of loans that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk rated and monitored collectively. These are typically loans to individuals in the classes which comprise the consumer portfolio segment.

 

The following are the definitions of the Company’s credit quality indicators:

 

Pass:Loans in all classes that comprise the commercial and consumer portfolio segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.

 

Watch:Loan paying as agreed with generally acceptable asset quality; however the obligor’s performance has not met expectations. Balance sheet and/or income statement has shown deterioration to the point that the obligor could not sustain any further setbacks. Credit is expected to be strengthened through improved obligor performance and/or additional collateral within a reasonable period of time.

 

Special Mention:Loans in the classes that comprise the commercial portfolio segment that have potential weaknesses that deserve management’s close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan. The special mention credit quality indicator is not used for classes of loans that comprise the consumer portfolio segment. Management believes that there is a moderate likelihood of some loss related to those loans that are considered special mention.

 

Classified:Classified (a) Substandard - Loans inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the company will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans classified substandard.

 

Classified (b) Doubtful - Loans that have all the weaknesses inherent in a loan classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors, which may work to the advantage and strengthening of the assets, its classification as an estimated loss is deferred until its more exact status may be determined.

 

 20 
Table of Contents  

 

The Company’s credit quality indicators are updated generally on a quarterly basis, but no less frequently than annually. The following table presents by class and by credit quality indicator, the recorded investment in the Company’s loans and leases as of March 31, 2018 and December 31, 2017.

 

(dollars in thousands)  Pass   Watch and
Special Mention
   Substandard   Doubtful   Total
Loans
 
                     
March 31, 2018                         
Commercial  $1,381,816   $28,758   $15,468   $   $1,426,042 
Income producing – commercial real estate   3,123,614    4,490    9,394        3,137,498 
Owner occupied – commercial real estate   756,551    36,425    7,771        800,747 
Real estate mortgage – residential   101,831    650    1,451        103,932 
Construction – commercial and residential   1,036,106        4,707        1,040,813 
Home equity   89,091    686    494        90,271 
Other consumer   3,131    1    91        3,223 
          Total  $6,492,140   $71,010   $39,376   $   $6,602,526 
                          
December 31, 2017                         
Commercial  $1,333,050   $34,163   $8,726   $   $1,375,939 
Income producing – commercial real estate   3,033,046    3,856    10,192        3,047,094 
Owner occupied – commercial real estate   696,754    53,189    5,501        755,444 
Real estate mortgage – residential   103,220    659    478        104,357 
Construction – commercial and residential   1,027,123        4,709        1,031,832 
Home equity   92,084    686    494        93,264 
Other consumer   3,505    2    91        3,598 
          Total  $6,288,782   $92,555   $30,191   $   $6,411,528 

 

Nonaccrual and Past Due Loans

 

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

 21 
Table of Contents  

 

The following table presents, by class of loan, information related to nonaccrual loans as of March 31, 2018 and December 31, 2017.

 

(dollars in thousands)  March 31, 2018   December 31, 2017 
         
Commercial  $3,595   $3,493 
Income producing - commercial real estate   50    832 
Owner occupied - commercial real estate   5,361    5,501 
Real estate mortgage - residential   1,745    775 
Construction - commercial and residential   2,051    2,052 
Home equity   494    494 
Other consumer   91    91 
Total nonaccrual loans (1)(2)  $13,387   $13,238 

 


 

(1)Excludes troubled debt restructurings (“TDRs”) that were performing under their restructured terms totaling $11.5 million at March 31, 2018 and $12.3 million at December 31, 2017.
(2)Gross interest income of $205 thousand and $304 thousand would have been recorded for the three months ended March 31, 2018 and 2017, respectively, if nonaccrual loans shown above had been current and in accordance with their original terms, while the interest actually recorded on such loans was zero and $90 thousand for the three months ended March 31, 2018 and 2017, respectively. See Note 1 to the Consolidated Financial Statements for a description of the Company’s policy for placing loans on nonaccrual status.

 

 22 
Table of Contents  

 

The following table presents, by class of loan, an aging analysis and the recorded investments in loans past due as of March 31, 2018 and December 31, 2017.

 

(dollars in thousands)  Loans
30-59 Days
Past Due
   Loans
60-89 Days
Past Due
   Loans
90 Days or
More Past Due
   Total Past
Due Loans
  

Current

Loans

   Total Recorded
Investment in
Loans
 
                         
March 31, 2018                              
Commercial  $6,179   $1,209   $3,595   $10,983   $1,415,059   $1,426,042 
Income producing – commercial real estate   13,452    4,562    50    18,064    3,119,434    3,137,498 
Owner occupied – commercial real estate   3,336    1,105    5,361    9,802    790,945    800,747 
Real estate mortgage – residential   6,590        1,745    8,335    95,597    103,932 
Construction – commercial and residential       5,268    2,051    7,319    1,033,494    1,040,813 
Home equity       90    494    584    89,687    90,271 
Other consumer   5    17    91    113    3,110    3,223 
Total  $29,562   $12,251   $13,387   $55,200   $6,547,326   $6,602,526 
                               
December 31, 2017                              
Commercial  $2,705   $748   $3,493   $6,946   $1,368,993   $1,375,939 
Income producing – commercial real estate   4,398    6,930    832    12,160    3,034,934    3,047,094 
Owner occupied – commercial real estate   522    3,906    5,501    9,929    745,515    755,444 
Real estate mortgage – residential   6,993    1,244    775    9,012    95,345    104,357 
Construction – commercial and residential       5,268    2,052    7,320    1,024,512    1,031,832 
Home equity   307        494    801    92,463    93,264 
Other consumer   45    6    91    142    3,456    3,598 
Total  $14,970   $18,102   $13,238   $46,310   $6,365,218   $6,411,528 

 

Impaired Loans

 

Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 

 23 
Table of Contents  

 

The following table presents, by class of loan, information related to impaired loans for the periods ended March 31, 2018 and March 31, 2017.

 

   Unpaid   Recorded   Recorded           Average Recorded   Interest Income
   Contractual   Investment   Investment   Total       Investment   Recognized 
   Principal   With No   With   Recorded   Related   Quarter   Year   Quarter   Year 
(dollars in thousands)  Balance   Allowance   Allowance   Investment   Allowance   To Date   To Date   To Date   To Date 
                                     
March 31, 2018                                             
Commercial  $4,944   $1,132   $3,693   $4,825   $3,014   $5,175   $5,175   $20   $20 
Income producing – commercial real estate   9,248        9,248    9,248    2,628    9,646    9,646    120    120 
Owner occupied – commercial real estate   6,432    5,650    782    6,432    500    6,514    6,514    11    11 
Real estate mortgage – residential   1,745    1,745        1,745        1,260    1,260         
Construction – commercial and residential   2,051    1,533    518    2,051    500    2,052    2,052         
Home equity   494    494        494        494    494         
Other consumer   91        91    91    80    91    91         
Total  $25,005   $10,554   $14,332   $24,886   $6,722   $25,232   $25,232   $151   $151 
                                              
March 31, 2017                                             
Commercial  $8,249   $2,843   $2,737   $5,580   $3,030   $5,604   $5,604   $42   $42 
Income producing – commercial real estate   10,019    702    9,317    10,019    1,488    12,478    12,478    48    48 
Owner occupied – commercial real estate   2,998    2,207    791    2,998    350    2,741    2,741         
Real estate mortgage – residential   310    310        310        433    433         
Construction – commercial and residential   3,255    2,717    538    3,255    350    2,664    2,664         
Other consumer   94        94    94    50    110    110         
Total  $24,925   $8,779   $13,477   $22,256   $5,268   $24,030   $24,030   $90   $90 

 

Modifications

 

A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying a loan. Commercial and industrial loans modified in a TDR often involve temporary interest-only payments, term extensions, and converting revolving credit lines to term loans. Additional collateral, a co-borrower, or a guarantor is often requested. Commercial mortgage and construction loans modified in a TDR often involve reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, or substituting or adding a new borrower or guarantor. Construction loans modified in a TDR may also involve extending the interest-only payment period. As of March 31, 2018, all performing TDRs were categorized as interest-only modifications.

 

Loans modified in a TDR for the Company may have the financial effect of increasing the specific allowance associated with the loan. An allowance for impaired consumer and commercial loans that have been modified in a TDR is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent. Management exercises significant judgment in developing these estimates.

 

 24 
Table of Contents  

 

The following table presents by class, the recorded investment of loans modified in TDRs held by the Company during the three months ended March 31, 2018 and 2017.

 

   For the Three Months Ended March 31, 2018 
(dollars in thousands)  Number of Contracts   Commercial   Income Producing - Commercial Real Estate   Owner Occupied - Commercial Real Estate   Construction - Commercial Real Estate   Total 
Troubled debt restructings                              
     Restructured accruing   8   $1,230   $9,198   $1,071   $   $11,499 
     Restructured nonaccruing   5    1,649                1,649 
Total   13   $2,879   $9,198   $1,071   $   $13,148 
                               
Specific allowance       $595   $2,350   $   $   $2,945 
                               
Restructured and subsequently defaulted       $   $121   $   $   $121 

 

   For the Three Months Ended March 31, 2017 
(dollars in thousands)  Number of Contracts   Commercial   Income Producing - Commercial Real Estate   Owner Occupied - Commercial Real Estate   Construction - Commercial Real Estate   Total 
Troubled debt restructings                              
     Restructured accruing   7   $3,137   $4,397   $367   $   $7,901 
     Restructured non-accruing   2    193            702    895 
Total   9   $3,330   $4,397   $367   $702   $8,796 
                               
Specific allowance       $855   $1,100   $   $   $1,955 
                               
Restructured and subsequently defaulted       $237   $   $   $   $237 

 

The Company had thirteen TDR’s at March 31, 2018 totaling approximately $13.1 million. Eight of these loans totaling approximately $11.5 million, are performing under their modified terms. During the three months of 2018, there was one default on a $121 thousand restructured loan which was charged off, as compared to the same period in 2017, which had one default on a $237 thousand restructured loan. A default is considered to have occurred once the TDR is past due 90 days or more or it has been placed on nonaccrual. There was one performing TDR totaling $786 thousand that was reclassified to nonperforming loans during the three months ended March 31, 2018, as compared to the same period in 2017, which had no performing TDRs reclassified to nonperforming loans. Commercial and consumer loans modified in a TDR are closely monitored for delinquency as an early indicator of possible future default. If loans modified in a TDR subsequently default, the Company evaluates the loan for possible further impairment. The allowance may be increased, adjustments may be made in the allocation of the allowance, or partial charge-offs may be taken to further write-down the carrying value of the loan. There were no loans modified in a TDR during the three months ended March 31, 2018 and 2017.

 

Note 6. Interest Rate Swap Derivatives

 

The Company uses interest rate swap agreements to assist in its interest rate risk management. The Company’s objective in using interest rate derivatives designated as cash flow hedges is to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company entered into forward starting interest rate swaps in April 2015 as part of its interest rate risk management strategy intended to mitigate the potential risk of rising interest rates on the Bank’s cost of funds. The notional amounts of the interest rate swaps designated as cash flow hedges do not represent amounts exchanged by the counterparties, but rather, the notional amount is used to determine, along with other terms of the derivative, the amounts to be exchanged between the counterparties. The interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from two counterparties in exchange for the Company making fixed payments beginning in April 2016. The Company’s intent is to hedge its exposure to the variability in potential future interest rate conditions on existing financial instruments.

 

As of March 31, 2018, the Company had three forward starting designated cash flow hedge interest rate swap transactions outstanding that had an aggregate notional amount of $250 million associated with the Company’s variable rate deposits. The net unrealized gain before income tax on the swaps was $4.8 million at March 31, 2018 compared to a net unrealized gain before income tax of $2.3 million at December 31, 2017. The gain in value since year end 2017 is due to the increase in expected net cash inflows from the swap over its remaining term due to higher market interest rates.

 

 25 
Table of Contents  

 

For derivatives designated as cash flow hedges, changes in the fair value of the derivative are initially reported in other comprehensive income (outside of earnings), net of tax, and subsequently reclassified to earnings when the hedged transaction affects earnings. The Company assesses the effectiveness of each hedging relationship by comparing the changes in cash flows of the derivative hedging instrument with the changes in cash flows of the designated hedged transactions.

 

Amounts reported in accumulated other comprehensive income related to designated cash flow hedge derivatives will be reclassified to interest income/expense as interest payments are made/received on the Company’s variable-rate assets/liabilities. During the quarter ended March 31, 2018, the Company reclassified $88 thousand related to designated cash flow hedge derivatives from accumulated other comprehensive income to interest expense. During the next twelve months, the Company estimates (based on existing interest rates) that $923 thousand will be reclassified as a decrease in interest expense.

 

The Company is exposed to credit risk in the event of nonperformance by the interest rate swap counterparty. The Company minimizes this risk by entering into derivative contracts with only large, stable financial institutions, and the Company has not experienced, and does not expect, any losses from counterparty nonperformance on the interest rate swaps. The Company monitors counterparty risk in accordance with the provisions of ASC Topic 815, “Derivatives and Hedging.” In addition, the interest rate swap agreements contain language outlining collateral-pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits.

 

The designated cash flow hedge interest rate swap agreements detail: 1) that collateral be posted when the market value exceeds certain threshold limits associated with the secured party’s exposure; 2) if the Company defaults on any of its indebtedness (including default where repayment of the indebtedness has not been accelerated by the lender), then the Company could also be declared in default on its derivative obligations; 3) if the Company fails to maintain its status as a well capitalized institution then the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.

 

As of March 31, 2018, the aggregate fair value of all designated cash flow hedge derivative contracts with credit risk contingent features (i.e., those containing collateral posting or termination provisions based on our capital status) that were in a net asset position totaled $4.8 million (none of these contracts were in a net liability position as of March 31, 2018). The Company has minimum collateral posting thresholds with certain of its derivative counterparties. As of March 31, 2018, the Company was not required to post collateral with its derivative counterparties against its obligations under these agreements because these agreements were in a net asset position. If the Company had breached any provisions under the agreements at March 31, 2018, it could have been required to settle its obligations under the agreements at the termination value.

 

The table below identifies the balance sheet category and fair values of the Company’s designated cash flow hedge derivative instruments as of March 31, 2018 and December 31, 2017.

 

       March 31, 2018  December 31, 2017
   Swap   Notional       Balance Sheet  Notional       Balance Sheet
   Number   Amount   Fair Value   Category  Amount   Fair Value   Category
                           
(dollars in thousands)                               
Interest rate swap   (1)  $75,000   $1,070   Other Assets  $75,000   $598   Other Assets
Interest rate swap   (2)   100,000    1,775   Other Assets   100,000    821   Other Assets
Interest rate swap   (3)   75,000    1,943   Other Assets   75,000    837   Other Assets
     Total    $250,000   $4,788      $250,000   $2,256    

 

 26 
Table of Contents  

 

The table below presents the pre-tax net gains (losses) of the Company’s cash flow hedges for the three months ended March 31, 2018 and 2017.

 

       Three Months Ended March 31, 2018   Three Months Ended March 31, 2017 
          Reclassified from AOCI into Income     Reclassified from AOCI into Income
   Swap
Number
   Amount of
Pre-tax gain (loss)
Recognized in OCI
   Category  Amount of
Gain (Loss)
   Amount of
Pre-tax gain (loss)
Recognized in OCI
   Category  Amount of
Gain (Loss)
 
                           
(dollars in thousands)                               
Interest rate swap   (1)  $471    Interest Expense  $(1)  $100    Interest Expense  $(154)
Interest rate swap   (2)   907    Interest Expense   (47)   35    Interest Expense   (231)
Interest rate swap   (3)   1,065    Interest Expense   (40)   328    Interest Expense   (193)
     Total    $2,443      $(88)  $463      $(578)

 

The table below presents the effect of the Company’s derivative financial instruments on the Consolidated Statements of Operations at March 31, 2018 and 2017.

 

   Location and Amount of Gain or (Loss) Recognized in Income on Cash Flow
Hedging Relationships 
 
   Three Months Ended March 31, 2018   Three Months Ended March 31, 2017 
(dollars in thousands)  Interest Income (Expense)   Other Income (Expense)   Interest Income (Expense)   Other Income (Expense) 
Total amounts of income and expense line items presented in the Consolidated Statements of Operations in which the effects of cash flow hedges are recorded  $(88)  $   $(578)  $ 
                     
The effects of cash flow hedging:                    
Gain or (loss) on cash flow hedging relationships in Subtopic 815-20                    
           Interest contracts                    
Amount of gain or (loss) reclassified from accumulated other comprehensive income into income  $(88)  $   $(578)  $ 

 

 27 
Table of Contents  

 

Balance Sheet Offsetting: Our designated cash flow hedge interest rate swap derivatives are eligible for offset in the Consolidated Balance Sheets and are subject to master netting arrangements. Our derivative transactions with counterparties are generally executed under International Swaps and Derivative Association (“ISDA”) master agreements which include “right of set-off” provisions. In such cases there is generally a legally enforceable right to offset recognized amounts and there may be an intention to settle such amounts on a net basis. The Company generally offsets such financial instruments for financial reporting purposes. The table below presents a gross presentation, the effects of offsetting, and a net presentation of the Company’s cash flow hedge derivatives as of March 31, 2018 and December 31, 2017.

 

Three Months Ended March 31, 2018
Offsetting of Derivative Assets (dollars in thousands)                
                  Gross Amounts Not Offset in the Balance Sheet 
    Gross Amounts of Recognized Assets    Gross Amounts Offset in the Balance Sheet    Net Amounts of Assets presented in the Balance Sheet    Financial Instruments    Cash Collateral Posted    Net Amount 
Counterparty 1  $3,706   $   $3,706   $   $   $3,706 
Counterparty 2   1,073        1,073            1,073 
   $4,779   $   $4,779   $   $   $4,779 

 

Year Ended December 31, 2017
Offsetting of Derivative Assets (dollars in thousands)                
                  Gross Amounts Not Offset in the Balance Sheet 
    Gross Amounts of Recognized Liabilities    Gross Amounts Offset in the Balance Sheet    Net Amounts of Liabilities presented in the Balance Sheet    Financial Instruments    Cash Collateral Posted    Net Amount 
Counterparty 1  $1,619   $   $1,619   $   $   $1,619 
Counterparty 2   582        582            582 
   $2,201   $   $2,201   $   $   $2,201 

 

Note 7. Other Real Estate Owned

 

The activity within Other Real Estate Owned (“OREO”) for the three months ended March 31, 2018 and the year ended December 31, 2017 is presented in the table below. There was one residential real estate loan in the process of foreclosure as of March 31, 2018 totaling $999 thousand. There were no residential real estate loans in the process of foreclosure as of March 31, 2017. For the three months ended March 31, 2018, there were no sales of OREO property, as compared to March 31, 2017 which had one sale for a net loss of $361 thousand with proceeds of $939 thousand.

 

   Three Months Ended   Year Ended 
(dollars in thousands)  March 31, 2018   December 31, 2017 
         
Balance at January 1,  $1,394   $2,694 
Real estate acquired from borrowers       1,145 
Valuation allowance        
Properties sold       (2,445)
Ending balance  $1,394   $1,394 

 

 28 
Table of Contents  

 

Note 8. Long-Term Borrowings

 

The following table presents information related to the Company’s long-term borrowings as of March 31, 2018 and December 31, 2017.

 

(dollars in thousands)  March 31, 2018   December 31, 2017 
         
Subordinated Notes, 5.75%  $70,000   $70,000 
Subordinated Notes, 5.0%   150,000    150,000 
Less: debt issuance costs   (2,997)   (3,095)
Long-term borrowings  $217,003   $216,905 

 

On August 5, 2014, the Company completed the sale of $70.0 million of its 5.75% subordinated notes, due September 1, 2024 (the “2024 Notes”). The 2024 Notes were offered to the public at par and qualify as Tier 2 capital for regulatory purposes to the fullest extent permitted under the Basel III Rule capital requirements. The net proceeds were approximately $68.8 million, which includes $1.2 million in deferred financing costs which are being amortized over the life of the 2024 Notes.

 

On July 26, 2016, the Company completed the sale of $150.0 million of its 5.00% Fixed-to-Floating Rate Subordinated Notes, due August 1, 2026 (the “2026 Notes”). The 2026 Notes were offered to the public at par and qualify as Tier 2 capital for regulatory purposes to the fullest extent permitted under the Basel III Rule capital requirements. The net proceeds were approximately $147.35 million, which includes $2.6 million in deferred financing costs which are being amortized over the life of the 2026 Notes.

 

Note 9. Net Income per Common Share

 

The calculation of net income per common share for the three months ended March 31, 2018 and 2017 was as follows.

 

   Three Months Ended March 31, 
(dollars and shares in thousands, except per share data)  2018   2017 
Basic:        
Net income available to common shareholders  $35,715   $27,017 
Average common shares outstanding   34,261    34,070 
Basic net income per common share  $1.04   $0.79 
           
Diluted:          
Net income available to common shareholders  $35,715   $27,017 
Average common shares outstanding   34,261    34,070 
Adjustment for common share equivalents   145    214 
Average common shares outstanding-diluted   34,406    34,284 
Diluted net income per common share  $1.04   $0.79 
           
Anti-dilutive shares       7 

 

Note 10. Stock-Based Compensation

 

The Company maintains the 2016 Stock Plan (“2016 Plan”), the 2006 Stock Plan (“2006 Plan”) and the 2011 Employee Stock Purchase Plan (“2011 ESPP”).

 

In connection with the acquisition of Virginia Heritage, the Company assumed the Virginia Heritage 2006 Stock Option Plan and the 2010 Long Term Incentive Plan (the “Virginia Heritage Plans”).

 

No additional options may be granted under the 2006 Plan or the Virginia Heritage Plans.

 

The Company adopted the 2016 Plan upon approval by the shareholders at the 2016 Annual Meeting held on May 12, 2016. The 2016 Plan provides directors and selected employees of the Bank, the Company and their affiliates with the opportunity to acquire shares of stock, through awards of options, time vested restricted stock, performance-based restricted stock and stock appreciation rights. Under the 2016 Plan, 1,000,000 shares of common stock were initially reserved for issuance.

 

 29 
Table of Contents  

 

For awards that are service based, compensation expense is being recognized over the service (vesting) period based on fair value, which for stock option grants is computed using the Black-Scholes model. For restricted stock awards granted under the 2016 plan, fair value is based on the Company’s closing price on the date of grant. For awards that are performance-based, compensation expense is recorded based on the probability of achievement of the goals underlying the grant. For restricted stock awards granted under the 2006 plan, fair value is based on the average of the high and low stock price of the Company’s shares on the date of grant.

 

In February 2018, the Company awarded 94,344 shares of time vested restricted stock to senior officers, directors, and certain employees. The shares vest in three substantially equal installments beginning on the first anniversary of the date of grant.

 

In February 2018, the Company awarded senior officers a targeted number of 42,533 performance vested restricted stock units (PRSUs). The vesting of PRSUs is 100% after three years with payouts based on threshold, target or maximum average performance targets over the three year period relative to a peer index. There are two performance metrics: 1) average annual earnings per share growth; and 2) average annual return on average assets. Each metric is measured against companies in the KBW Regional Banking Index.

 

The Company has unvested restricted stock awards and PRSU grants of 274,796 shares at March 31, 2018. Unrecognized stock based compensation expense related to restricted stock awards and PRSU grants totaled $13.5 million at March 31, 2018. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 2.33 years.

 

The following tables summarize the unvested restricted stock awards activity for the three months ended March 31, 2018 and 2017.

 

   Three Months Ended March 31, 
   2018   2017 
Perfomance Awards  Shares   Weighted-Average Grant Date Fair Value   Shares   Weighted-Average Grant Date Fair Value 
                 
Unvested at beginning   62,338   $50.45    33,226   $42.60 
Issued   42,533    60.45    36,523    57.49 
Forfeited   (5,913)   50.28         
Vested                
Unvested at end   98,958   $54.76    69,749   $50.40 

 

   Three Months Ended March 31, 
   2018   2017 
Time Vested Awards  Shares   Weighted-Average Grant Date Fair Value   Shares   Weighted-Average Grant Date Fair Value 
                 
Unvested at beginning   164,043   $53.57    262,966   $33.60 
Issued   94,344    60.45    91,097    62.70 
Forfeited   (5,165)   55.60    (371)   42.93 
Vested   (77,384)   49.67    (176,134)   28.73 
Unvested at end   175,838   $58.92    177,558   $53.34 

 

 30 
Table of Contents  

 

Below is a summary of stock option activity for the three months ended March 31, 2018 and 2017. The information excludes restricted stock units and awards.

 

   Three Months Ended March 31, 
   2018   2017 
   Shares   Weighted-Average Exercise Price   Shares   Weighted-Average Exercise Price 
                 
Beginning balance   143,224   $9.13    216,859   $8.80 
Issued                
Exercised   (32,230)   10.48    (2,675)   24.67 
Forfeited   (500)   24.86         
Expired                
Ending balance   110,494   $8.67    214,184   $8.60 

 

The following summarizes information about stock options outstanding at March 31, 2018. The information excludes restricted stock units and awards.

 

                Weighted-Average 
Outstanding:   Stock Options   Weighted-Average   Remaining 
Range of Exercise Prices   Outstanding   Exercise Price   Contractual Life 
$5.76   $10.72    97,995   $5.76    0.78 
$10.73   $11.40    5,089    11.17    3.63 
$11.41   $24.86    660    20.03    4.82 
$24.87   $49.91    6,750    47.83    7.87 
           110,494   $8.67    1.36 

 

Exercisable:   Stock Options   Weighted-Average 
Range of Exercise Prices   Exercisable   Exercise Price 
$5.76   $10.72    80,646   $5.76 
$10.73   $11.40    5,089    11.17 
$11.41   $24.86    660    20.03 
$24.87   $49.91    2,000    47.62 
           88,395   $7.13 

 

The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model with the assumptions as shown in the table below used for grants during the years ended December 31, 2017 and 2016. There were no grants of stock options during the three months ended March 31, 2018.

  

   Three Months Ended   Years Ended December 31, 
   March 31, 2018   2017   2016 
Expected volatility   n/a    n/a    24.23%
Weighted-Average volatility   n/a    n/a    24.23%
Expected dividends            
Expected term (in years)   n/a    n/a    7.0 
Risk-free rate   n/a    n/a    1.37%
Weighted-average fair value (grant date)   n/a    n/a   $14.27 

 

The total intrinsic value of outstanding stock options was $5.7 million and $11.0 million, respectively, at March 31, 2018 and 2017. The total intrinsic value of stock options exercised during the three months ended March 31, 2018 and 2017 was $1.6 million and $103 thousand. The total fair value of stock options vested was $34 thousand for both the three months ended March 31, 2018 and 2017. Unrecognized stock-based compensation expense related to stock options totaled $57 thousand at March 31, 2018. At such date, the weighted-average period over which this unrecognized expense was expected to be recognized was 1.76 years.

 

 31 
Table of Contents  

 

Approved by shareholders in May 2011, the 2011 ESPP reserved 550,000 shares of common stock (as adjusted for stock dividends) for issuance to employees. Whole shares are sold to participants in the plan at 85% of the lower of the stock price at the beginning or end of each quarterly offering period. The 2011 ESPP is available to all eligible employees who have completed at least one year of continuous employment, work at least 20 hours per week and at least five months a year. Participants may contribute a minimum of $10 per pay period to a maximum of $6,250 per offering period or $25,000 annually (not to exceed more than 10% of compensation per pay period). At March 31, 2018, the 2011 ESPP had 399,383 shares reserved for issuance.

 

Included in salaries and employee benefits in the accompanying Consolidated Statements of Operations, the Company recognized $1.5 million and $1.9 million in stock-based compensation expense for the three months ended March 31, 2018 and 2017, respectively. Stock-based compensation expense is recognized ratably over the requisite service period for all awards.

 

Note 11. Other Comprehensive Income

 

The following table presents the components of other comprehensive income (loss) for the three months ended March 31, 2018 and 2017.

 

(dollars in thousands)  Before Tax   Tax Effect   Net of Tax 
             
Three Months Ended March 31, 2018               
Net unrealized loss on securities available-for-sale  $(6,221)  $1,098   $(5,123)
Less: Reclassification adjustment for net gains included in net income   (42)   (11)   (31)
Total unrealized loss   (6,263)   1,087    (5,154)
                
Net unrealized gain on derivatives   2,607    374    2,233 
Less: Reclassification adjustment for losses included in net income   (88)   (23)   (65)
Total unrealized gain   2,519    351    2,168 
                
Other Comprehensive Loss  $(3,744)  $1,438   $(2,986)
                
Three Months Ended March 31, 2017               
Net unrealized gain on securities available-for-sale  $1,165   $453   $712 
Less: Reclassification adjustment for net gains included in net income   (505)   (183)   (322)
Total unrealized gain   660    270    390 
                
Net unrealized gain on derivatives   1,752    673    1,079 
Less: Reclassification adjustment for losses included in net income   (578)   (209)   (369)
Total unrealized gain   1,174    464    710 
                
Other Comprehensive Income  $1,834   $734   $1,100 

 

 32 
Table of Contents  

 

The following table presents the changes in each component of accumulated other comprehensive loss, net of tax, for the three months ended March 31, 2018 and 2017.

 

(dollars in thousands)  Securities Available For Sale   Derivatives   Accumulated Other Comprehensive Income (Loss) 
             
Three Months Ended March 31, 2018               
Balance at Beginning of Period  $(3,131)  $1,381   $(1,750)
Other comprehensive income (loss) before reclassifications   (5,123)   2,233    (2,890)
Amounts reclassified from accumulated other comprehensive income (loss)   (31)   (65)   (96)
Total other comprehensive income (loss)   (5,154)   2,168    (2,986)
Reclassification of the Income Tax Effects of the Tax Cuts and Jobs Act from AOCI   (674)       (674)
Balance at End of Period  $(8,959)  $3,549   $(5,410)
                
Three Months Ended March 31, 2017               
Balance at Beginning of Period  $(1,955)  $(426)  $(2,381)
Other comprehensive income before reclassifications   712    1,079    1,791 
Amounts reclassified from accumulated other comprehensive income   (322)   (369)   (691)
Total other comprehensive income   390    710    1,100 
Balance at End of Period  $(1,565)  $284   $(1,281)

 

 

The following table presents the amounts reclassified out of each component of accumulated other comprehensive (loss) income for the three months ended March 31, 2018 and 2017.

 

Details about Accumulated Other
Comprehensive Income Components
(dollars in thousands)
  Amount Reclassified from
Accumulated Other
Comprehensive (Loss) Income
   Affected Line Item in
the Statement Where
Net Income is Presented
        
    March 31, 2018    March 31, 2017    
Realized gain on sale of investment securities  $42   $505   Gain on sale of investment securities
Interest expense derivative deposits   (88)   (578)  Interest expense on deposits
    12    26   Tax expense
Total Reclassifications for the Period  $(34)  $(47)  Net Income

 

 33 
Table of Contents  

 

Note 12. Fair Value Measurements

 

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. In estimating fair value, the Company utilizes valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Such valuation techniques are consistently applied. Inputs to valuation techniques include the assumptions that market participants would use in pricing an asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

 

Level 1Quoted prices in active exchange markets for identical assets or liabilities; also includes certain U.S. Treasury and other U.S. Government and agency securities actively traded in over-the-counter markets.
   
Level 2Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data; also includes derivative contracts whose value is determined using a pricing model with observable market inputs or can be derived principally from or corroborated by observable market data. This category generally includes certain U.S. Government and agency securities, corporate debt securities, derivative instruments, and residential mortgage loans held for sale.
   
Level 3Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs for single dealer nonbinding quotes not corroborated by observable market data. This category generally includes certain private equity investments, retained interests from securitizations, and certain collateralized debt obligations.

 

 34 
Table of Contents  

 

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

 

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis as of March 31, 2018 and December 31, 2017.

 

(dollars in thousands)  Quoted Prices
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant Other
Unobservable Inputs
(Level 3)
   Total
(Fair Value)
 
March 31, 2018                    
Assets:                    
Investment securities available for sale:                    
U. S. agency securities  $   $192,091   $   $192,091 
Residential mortgage backed securities       329,240        329,240 
Municipal bonds       48,605        48,605 
Corporate bonds       6,663    1,500    8,163 
Other equity investments           218    218 
Loans held for sale       25,873        25,873 
Mortgage banking derivatives           51    51 
Interest rate swap derivatives       4,788        4,788 
Total assets measured at fair value on a recurring basis
as of March 31, 2018
  $   $607,260   $1,769   $609,029 
                     
Liabilities:                    
Mortgage banking derivatives  $   $   $84   $84 
Interest rate swap derivatives       13        13 
Total liabilities measured at fair value on a recurring basis
as of March 31, 2018
  $   $13   $84   $97 
                     
December 31, 2017                    
Assets:                    
Investment securities available for sale:                    
U. S. agency securities  $   $195,984   $   $195,984 
Residential mortgage backed securities       317,836        317,836 
Municipal bonds       62,057        62,057 
Corporate bonds       11,673    1,500    13,173 
Other equity investments           218    218 
Loans held for sale       25,096        25,096 
Mortgage banking derivatives           43    43 
Interest rate swap derivatives       2,256        2,256 
Total assets measured at fair value on a recurring basis
as of December 31, 2017
  $   $614,902   $1,761   $616,663 
                     
Liabilities:                    
Mortgage banking derivatives  $   $   $10   $10 
Interest rate swap derivatives                
Total liabilities measured at fair value on a recurring basis
as of December 31, 2017
  $   $   $10   $10 

 

Investment Securities Available-for-Sale: Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include U.S. agency debt securities, mortgage backed securities issued by Government Sponsored Entities (“GSE’s”) and municipal bonds. Securities classified as Level 3 include securities in less liquid markets, the carrying amounts approximate the fair value.

 

Loans held for sale: The Company has elected to carry loans held for sale at fair value. This election reduces certain timing differences in the Consolidated Statement of Operations and better aligns with the management of the portfolio from a business perspective. Fair value is derived from secondary market quotations for similar instruments. Gains and losses on sales of residential mortgage loans are recorded as a component of noninterest income in the Consolidated Statements of Operations. Gains and losses on sales of multifamily FHA securities are recorded as a component of noninterest income in the Consolidated Statements of Operations. As such, the Company classifies loans subjected to fair value adjustments as Level 2 valuation.

 

 35 
Table of Contents  

 

The following table summarizes the difference between the aggregate fair value and the aggregate unpaid principal balance for loans held for sale measured at fair value as of March 31, 2018 and December 31, 2017.

 

   March 31, 2018 
(dollars in thousands)  Fair Value   Aggregate Unpaid Principal Balance   Difference 
             
Residential mortgage loans held for sale  $25,873   $25,469   $404 
FHA mortgage loans held for sale  $   $   $ 

 

   December 31, 2017 
(dollars in thousands)  Fair Value   Aggregate Unpaid Principal Balance   Difference 
             
Residential mortgage loans held for sale  $25,096   $24,674   $422 
FHA mortgage loans held for sale  $   $   $ 

 

No residential mortgage loans held for sale were 90 or more days past due or on nonaccrual status as of March 31, 2018 or December 31, 2017.

 

Interest rate swap derivatives: These derivative instruments consist of forward starting interest rate swap agreements, which are accounted for as cash flow hedges under ASC 815. The Company’s derivative position is classified within Level 2 of the fair value hierarchy and is valued using models generally accepted in the financial services industry and that use actively quoted or observable market input values from external market data providers and/or non-binding broker-dealer quotations. The fair value of the derivatives is determined using discounted cash flow models. These models’ key assumptions include the contractual terms of the respective contract along with significant observable inputs, including interest rates, yield curves, nonperformance risk and volatility. Derivative contracts are executed with a Credit Support Annex, which is a bilateral agreement that requires collateral postings when the market value exceeds certain threshold limits. These agreements protect the interests of the Company and its counterparties should either party suffer a credit rating deterioration.

 

Mortgage banking derivatives: The Company relies on a third-party pricing service to value its mortgage banking derivative financial assets and liabilities, which the Company classifies as a Level 3 valuation. The external valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale includes grouping the interest rate lock commitments by interest rate and terms, applying an estimated pull-through rate based on historical experience, and then multiplying by quoted investor prices determined to be reasonably applicable to the loan commitment groups based on interest rate, terms, and rate lock expiration dates of the loan commitment groups. The Company also relies on an external valuation model to estimate the fair value of its forward commitments to sell residential mortgage loans (i.e., an estimate of what the Company would receive or pay to terminate the forward delivery contract based on market prices for similar financial instruments), which includes matching specific terms and maturities of the forward commitments against applicable investor pricing.

 

 36 
Table of Contents  

 

The following is a reconciliation of activity for assets and liabilities measured at fair value based on Significant Other Unobservable Inputs (Level 3):

 

(dollars in thousands)  Investment Securities   Mortgage Banking Derivatives   Total 
Assets:               
Beginning balance at January 1, 2018  $1,718   $43   $1,761 
Realized loss included in earnings - net mortgage banking derivatives       8    8 
Purchases of available-for-sale securities            
Principal redemption            
Ending balance at March 31, 2018  $1,718   $51   $1,769 
                
Liabilities:               
Beginning balance at January 1, 2018  $   $10   $10 
Realized loss included in earnings - net mortgage banking derivatives       74    74 
Principal redemption            
Ending balance at March 31, 2018  $   $84   $84 

 

(dollars in thousands)  Investment Securities   Mortgage Banking Derivatives   Total 
Assets:               
Beginning balance at January 1, 2017  $1,718   $114   $1,832 
Realized loss included in earnings - net mortgage banking derivatives       (71)   (71)
Purchases of available-for-sale securities            
Principal redemption            
Ending balance at December 31, 2017  $1,718   $43   $1,761 
                
Liabilities:               
Beginning balance at January 1, 2017  $   $55   $55 
Realized loss included in earnings - net mortgage banking derivatives       (45)   (45)
Principal redemption            
Ending balance at December 31, 2017  $   $10   $10 

 

The other equity securities classified as Level 3 consist of equity investments in the form of common stock of two local banking companies which are not publicly traded, and for which the carrying amount approximates fair value.

 

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

 

The Company measures certain assets at fair value on a nonrecurring basis and the following is a general description of the methods used to value such assets.

 

Impaired loans: The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and an allowance for loan loss is established. The Company considers a loan impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement, including both principal and interest. Management has determined that nonaccrual loans and loans that have had their terms restructured in a troubled debt restructuring meet this impaired loan definition. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Receivables.” The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. At March 31, 2018, substantially all of the Company’s impaired loans were evaluated based upon the fair value of the collateral. In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3. For individually evaluated impaired loans, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the estimated fair value of the underlying collateral for collateral-dependent loans, which the Company classifies as a Level 3 valuation.

 

 37 
Table of Contents  

 

Other real estate owned: Other real estate owned is initially recorded at fair value less estimated selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral, which the Company classifies as a Level 3 valuation. Assets measured at fair value on a nonrecurring basis are included in the table below:

 

(dollars in thousands)  Quoted Prices
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant Other
Unobservable Inputs
(Level 3)
   Total
(Fair Value)
 
March 31, 2018                    
Impaired loans:                    
Commercial  $   $   $1,811   $1,811 
Income producing - commercial real estate           6,620    6,620 
Owner occupied - commercial real estate           5,932    5,932 
Real estate mortgage - residential           1,745    1,745 
Construction - commercial and residential           1,551    1,551 
Home equity           494    494 
Other consumer           11    11 
Other real estate owned           1,394    1,394 
Total assets measured at fair value on a nonrecurring basis
as of March 31, 2018
  $   $   $19,558   $19,558 

 

(dollars in thousands)  Quoted Prices
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant Other
Unobservable Inputs
(Level 3)
   Total
(Fair Value)
 
December 31, 2017                    
Impaired loans:                    
Commercial  $   $   $2,266   $2,266 
Income producing - commercial real estate           7,664    7,664 
Owner occupied - commercial real estate           5,214    5,214 
Real estate mortgage - residential           775    775 
Construction - commercial and residential           1,552    1,552 
Home equity           494    494 
Other consumer           11    11 
Other real estate owned           1,394    1,394 
Total assets measured at fair value on a nonrecurring basis
as of December 31, 2017
  $   $   $19,370   $19,370 

 

Fair Value of Financial Instruments

 

The Company discloses fair value information about financial instruments for which it is practicable to estimate the value, whether or not such financial instruments are recognized on the balance sheet. Fair value is the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation, and is best evidenced by quoted market price, if one exists.

 

Quoted market prices, if available, are shown as estimates of fair value. Because no quoted market prices exist for a portion of the Company’s financial instruments, the fair value of such instruments has been derived based on management’s assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instrument values and should not be considered an indication of the fair value of the Company taken as a whole.

 

 38 
Table of Contents  

 

The following methods and assumptions were used to estimate the fair value of each category of financial instrument for which it is practicable to estimate value:

 

Cash due from banks and federal funds sold: For cash and due from banks and federal funds sold the carrying amount approximates fair value.

 

Interest bearing deposits with other banks: For interest bearing deposits with other banks the carrying amount approximates fair value.

 

Investment securities: For these instruments, fair values are based upon quoted prices, if available. If quoted prices are not available, fair value is measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.

 

Federal Reserve and Federal Home Loan Bank stock: The carrying amounts approximate the fair values at the reporting date.

 

Loans held for sale: As the Company has elected the fair value option, the fair value of loans held for sale is the carrying value and is based on commitments outstanding from investors as well as what secondary markets are currently offering for portfolios with similar characteristics for residential mortgage loans held for sale since such loans are typically committed to be sold (servicing released) at a profit. The fair value of multifamily FHA loans held for sale is the carrying value and is based on commitments outstanding from investors as well as what secondary markets are currently offering for portfolios with similar characteristics for multifamily FHA loans held for sale since such loans are typically committed to be securitized and sold (servicing retained) at a profit.

 

Loans: The loan portfolio is valued using an exit price notion. The present value of cash flows projection is established for each loan in the portfolio projecting contractual payments, default adjusted payments, cash flows in the event of default (including deferred timing of recoveries), and pre-payments. These expected cash flows are then discounted to present value using the note interest rate and an established market rate which, if different from the note rate, allows the Bank to isolate the amount above or below par a potential acquirer would pay to acquire the Bank’s portfolio.

 

Bank owned life insurance: The fair value of bank owned life insurance is the current cash surrender value, which is the carrying value.

 

Annuity investment: The fair value of the annuity investments is the carrying amount at the reporting date.

 

Mortgage banking derivatives: The Company enters into interest rate lock commitments with prospective residential mortgage borrowers. These commitments are carried at fair value based on the fair value of the underlying mortgage loans which are based on market data. These commitments are classified as Level 3 in the fair value disclosures, as the valuations are based on market unobservable inputs. The Company hedges the risk of the overall change in the fair value of loan commitments to borrowers by selling forward contracts on securities of GSEs. These forward settling contracts are classified as Level 3, as valuations are based on market unobservable inputs. See Note 4 to the Consolidated Financial Statements for additional detail.

 

Interest rate swap derivatives: These derivative instruments consist of forward starting interest rate swap agreements, which are accounted for as cash flow hedges. The Company’s derivative position is classified within Level 2 of the fair value hierarchy and is valued using models generally accepted in the financial services industry and that use actively quoted or observable market input values from external market data providers and/or non-binding broker-dealer quotations. The fair value of the derivatives is determined using discounted cash flow models. These models’ key assumptions include the contractual terms of the respective contract along with significant observable inputs, including interest rates, yield curves, nonperformance risk and volatility. Derivative contracts are executed with a Credit Support Annex, which is a bilateral ratings-sensitive agreement that requires collateral postings when the market value exceeds certain threshold limits. These agreements protect the interests of the Company and its counterparties should either party suffer a credit rating deterioration.

 

 39 
Table of Contents  

 

Noninterest bearing deposits: The fair value of these deposits is the amount payable on demand at the reporting date, since generally accepted accounting standards do not permit an assumption of core deposit value.

 

Interest bearing deposits: The fair value of interest bearing transaction, savings, and money market deposits with no defined maturity is the amount payable on demand at the reporting date, since generally accepted accounting standards do not permit an assumption of core deposit value.

 

Certificates of deposit: The fair value of certificates of deposit is estimated by discounting the future cash flows using the current rates at which similar deposits with remaining maturities would be accepted.

 

Customer repurchase agreements: The carrying amount approximate the fair values at the reporting date.

 

Borrowings: The carrying amount for variable rate borrowings approximate the fair values at the reporting date. The fair value of fixed rate FHLB advances and the subordinated notes are estimated by computing the discounted value of contractual cash flows payable at current interest rates for obligations with similar remaining terms. The fair value of variable rate FHLB advances is estimated to be carrying value since these liabilities are based on a spread to a current pricing index.

 

Off-balance sheet items: Management has reviewed the unfunded portion of commitments to extend credit, as well as standby and other letters of credit, and has determined that the fair value of such instruments is equal to the fee, if any, collected and unamortized for the commitment made.

 

 40 
Table of Contents  

 

The estimated fair values of the Company’s financial instruments at March 31, 2018 and December 31, 2017 are as follows:

 

           Fair Value Measurements 
(dollars in thousands)  Carrying
Value
   Fair
Value
   Quoted Prices
(Level 1)
   Significant Other
Observable
Inputs
(Level 2)
  

Significant 
Unobservable Inputs

(Level 3)

 
March 31, 2018                         
Assets                         
Cash and due from banks  $7,954   $7,954   $   $7,954   $ 
Federal funds sold   29,552    29,552        29,552     
Interest bearing deposits with other banks   167,347    167,347        167,347     
Investment securities   578,317    578,317        576,599    1,718 
Federal Reserve and Federal Home Loan Bank stock   34,768    34,768        34,768     
Loans held for sale   25,873    25,873        25,873     
Loans (1)   6,536,719    6,564,036            6,564,036 
Bank owned life insurance   61,291    61,291        61,291     
Annuity investment   11,463    11,463        11,463     
Mortgage banking derivatives   51    51            51 
Interst rate swap derivatives   4,788    4,788        4,788     
                          
Liabilities                         
Noninterest bearing deposits   1,909,210    1,909,210        1,909,210     
Interest bearing deposits   3,134,707    3,134,707        3,134,707     
Certificates of deposit   1,077,884    1,074,200        1,074,200     
Customer repurchase agreements   48,365    48,365        48,365     
Borrowings   492,003    497,066        497,066     
Mortgage banking derivatives   84    84            84 
                          
December 31, 2017                         
Assets                         
Cash and due from banks  $7,445   $7,445   $   $7,445   $ 
Federal funds sold   15,767    15,767        15,767     
Interest bearing deposits with other banks   167,261    167,261        167,261     
Investment securities   589,268    589,268        587,550    1,718 
Federal Reserve and Federal Home Loan Bank stock   36,324    36,324        36,324     
Loans held for sale   25,096    25,096        25,096     
Loans (2)   6,346,770    6,381,213            6,381,213 
Bank owned life insurance   60,947    60,947        60,947     
Annuity investment   11,632    11,632        11,632     
Mortgage banking derivatives   43    43            43 
Interst rate swap derivatives   2,256    2,256        2,256     
                          
Liabilities                         
Noninterest bearing deposits   1,982,912    1,982,912        1,982,912     
Interest bearing deposits   3,041,563    3,041,563        3,041,563     
Certificates of deposit   829,509    829,886        829,886     
Customer repurchase agreeme